Rarely has the gap between the bull versus bear case on the economy been so wide. The bulls say the advance in the broad equity market, despite its narrow breadth, argues against a recession in the second half of this year. Yet, the bears say that the trusted inverted yield curve indicator, or the spread between 3-month Treasury bills and the 10-year Treasury note, shows the most inversion in almost 50 years, signaling a recession in the months immediately ahead. Who's right? Can both be wrong?
The bull/bear case rests on the housing sector. A sharp decline in housing construction, between 40% and 80% from cycle peak levels, preceded the start of every recession. That, in turn, triggered a sharp drop in jobs, income, and spending. Only once in the post-war period did the economy enter into recession without a sharp plunge in housing construction. That happened in 2000 when the tech-equity bubble burst, triggering a series of corporate bankruptcies and a two-year decline in capital spending.
None of that is happening nowadays. Housing starts through the first four months of 2023 are off 10% from the 2022 level, but the April level is 5% up from the January lows. Also, builders are becoming more optimistic about current and future sales based on the NAHB survey conducted in May.
Meanwhile, the broad equity market is up 8% in 2023, and homebuilders are one of the best-performing industry sectors. Last week, the S&P homebuilder index hit a new 52-week high, signaling from an investor's perspective better times ahead for the housing industry. Also, the tech-heavy index NASDAQ, which plunged in 2000 and triggered the only non-housing recession, has registered 20%-plus gains in 2023.
Can the bear case unravel without impacting the bull case if it is wrong? Ironically, the bull case needs part of the bear case to be correct. The bear case thinks that the 500 basis points increase in official rates over the past year is sufficient to curtail demand, slow the economy, and reverse the rise in inflation. The bull case also thinks that interest rates have peaked, and the Fed will, in time, re-establish a positively sloping yield curve by cutting official rates.
Last week, Fed Powell stated, "Our policy rate may not need to rise as much as it would have otherwise to achieve our goals," given tightening credit conditions." Yet, if the economy is gaining renewed momentum, based on housing and equity prices, that blows a hole in the bear case that interest rates have peaked, undermines the bull case, and Powell is wrong again.